Friday, August 27, 2010

I expect that some of you are completely lost in the
debate over the relationship between interest rates and inflation that has
been going on lately. I'm hoping this will provide some
general background on monetary models that will help to sort things out, at least at a very general level.

But the main reason for doing this is to emphasize something that has not
been talked about much, how the empirical evidence led economists to move away
from flexible price models and consider models featuring wage and price
rigidities (and for those of you ready to jump on me about the empirical
evidence regarding wage and price rigidities, how the evidence changes with
disaggregation and the like, those objections have been presented here, e.g. see
this post for one example, or even better, see
here, or better yet, scroll down
here).

This is an important, too little discussed point. In models with flexible
prices, matching the short-run dynamics contained in actual U.S. data with a
defensible theoretical model is a challenge, one that can only be overcome with
assumptions that are highly unpalatable. We do much better when we add wage
inflexibility, but that alone is not enough to get both the size and the sign of
all the correlations in the data correct, and it also fails to match the
magnitude and duration of the responses to shocks. When price rigidities are
tacked onto the model so that both price and wage inflexibilities are present,
we get much closer in matching signs of correlations, durations, and magnitudes contained within
U.S. data.

Even then, problems remain. One has to do with whether the actual degree of
price rigidity in the data is enough to generate the persistence and magnitudes
that are needed -- that's the point of the papers linked above. Another is the
need to assume unrealistic values for labor supply elasticities in order to get
the right degree of labor responsiveness in the model. The values needed do not
match the estimated values. In addition, the Calvo pricing assumption is often
attacked as ad hoc instead of being derived from first principles, an
unrealistic approximation of the true process (e.g. it's not state dependent), and
so forth. And this list is by no means exhaustive.

But these models -- New Keynesian models -- are the best we have presently in
terms of matching the data empirically. Some proponents of alternatives, e.g.
flexible price models, will protest that they can, in fact, do as well or better
at matching the data, but they will rely upon assumptions, decompositions, shock
characteristics and the like that the larger profession has deemed
unsupportable. When the proponents of alternatives to the New Keynesian model
produce a model of their own that does a better job of explaining the data
without resorting to these assumptions, then it will be time to pay more
attention. But for now, for policy analysis in particular, the New Keynesian
models are the best we have. I understand that, particularly recently, best does
not necessarily imply good -- the models need to be fixed and some people,
like Stiglitz don't think they can be fixed at all. But, again, for now they
are the best we have, particularly in terms of matching the empirical evidence
and for policy analysis.

This is from Carl Walsh's
book "Monetary Theory and Policy" (I need to get my hands on his 3rd
edition). The sections below provide some background on the evolution of monetary models, as
well as more on the point about needing wage and price rigidities to match the
empirical evidence:

2 Money-in-the-Utility Function2.1 IntroductionThe neoclassical growth model, due to Ramsey (1928) and Solow (1956),
provides the basic framework for much of modern macroeconomics. Solow's growth
model has just three key ingredients: a production function allowing for smooth
substitutability between labor and capital in the production of output, a
capital accumulation process in which a fixed fraction of output is devoted to
investment each period, and a labor supply process in which the quantity of
labor input grows at an exogenously given rate. Solow showed that such an
economy would converge to a steady-state growth path along which output, the
capital stock, and the effective supply of labor all grew at the same rate.

When the assumption of a fixed savings rate is replaced by a model of
forward-looking households choosing savings and labor supply to maximize
lifetime utility, the Solow model becomes the foundation for dynamic stochastic
models of the business cycle. Productivity shocks or other real disturbances
affect output and savings behavior, with the resultant effect on capital
accumulation propagating the effects of the original shock over time in ways
that can mimic some features of actual business cycles (see Cooley 1995).

The neoclassical growth model is a model of a nonmonetary economy, and
while goods are exchanged and transactions must be taking place, there is no
medium of exchange -- that is, no "money" -- that is used to facilitate these
transactions. Nor is there an asset, like money, that has a zero nominal rate of
return and is therefore dominated in rate of return by other interest-bearing
assets. To employ the neoclassical framework to analyze monetary issues, a role
for money must be specified so that the agents will wish to hold positive
quantities of money. A positive demand for money is necessary if, in
equilibrium, money is to have positive value.

A fundamental question in monetary economics is the following: How should we
model the demand for money? How do real economies differ from Arrow-Debreu
economies in ways that give rise to a positive value for money? Three general
approaches to incorporating money into general equilibrium models have been
followed: (1) assume that money yields direct utility by incorporating money
balances directly into the utility functions of the agents of the model (Sidrauski
1967); (2) impose transactions costs of some form that give rise to a demand for
money, either by making asset exchanges costly (Baumol 1952; Tobin 1956),
requiring that money be used for certain types of transactions (Clower 1967),
assuming that time and money can be combined to produce transaction services
that are necessary for obtaining consumption goods, or assuming that direct
barter of commodities is costly (Kiyotaki and Wright 1989); or (3) treat money
like any other asset used to transfer resources intertemporally (Samuelson
1958). All involve shortcuts in one form or another... An important
consideration in evaluating different approaches will be to determine whether
conclusions generalize beyond the specific model or are dependent on the exact
manner in which a role for money has been introduced. We will see examples of
results that are robust, such as the connection between money growth and
inflation, and others that are sensitive to the specification of money's role,
such as the impact of inflation on the steady-state capital stock. ...

The ... assumption that prices and wages are perfectly flexible will be
maintained... Thus, the focus is on flexible price models that emphasize the
transactions role of money. The approaches adopted in these models can also be
used to incorporate money into models in which prices and/or wages are sticky.
The implications of introducing nominal rigidities into general equilibrium
models of monetary economies are discussed in [later] chapters...

3.5 Summary
The models we have examined in this and the previous chapter are variants of
Walrasian economies in which prices are perfectly flexible and adjust to ensure
that market equilibrium is continuously maintained. The ... approaches discussed
all represent means of introducing valued money into the Walrasian equilibrium.
Each approach captures some aspects of the role that money plays in facilitating
transactions. ...

However, the dynamics implied by these flexible-price models fail to capture the
short-run behavior that appears to characterize modem economies.

That is perhaps not surprising; most economists believe that sluggish wage and
price adjustment, absent from the models of this chapter, play critical roles in
determining the short-run real effects of monetary disturbances and monetary
policy. Although systematic monetary policy can have real effects with flexible
prices, simulations suggest that these effects are small, at least at moderate
inflation rates. To understand how the observed short-run behavior of money,
interest rates, the price level, and output might be generated in a monetary
economy, we need to introduce nominal rigidities, a topic discussed in chapter
5. ...

5 Money, Output, and Inflation in the Short Run5.1 Introduction
Chapter 1 provided evidence that monetary policy actions have effects on real
output that persist for appreciable periods of time. The empirical evidence from
the United States is consistent with the notion that positive monetary shocks
lead to a hump-shaped positive response of output, and Sims (1992) finds similar
patterns for other OECD economies. We have not yet discussed why such a response
is produced.

Certainly the models of chapters 2-4 did not seem capable of producing such an
effect. So why does money matter? Is it only through the tax effects that arise
from inflation? Or are there other channels through which monetary actions have
real effects? This question is critical for any normative analysis of monetary
policy, since designing good policy requires understanding how monetary policy
affects the real economy and how changes in the way policy is conducted might
affect economic behavior.

In the models examined in earlier chapters, monetary disturbances did cause
output movements, but these movements arose from substitution effects induced by
expected inflation. The simulation exercises suggested that these effects were
too small to account for the empirical evidence on the output responses to
monetary shocks. In addition, the evidence in many countries is that inflation
responds only slowly to monetary shocks. If actual inflation responds gradually,
so should expectations. Thus, the evidence does not appear supportive of
theories that require monetary shocks to affect labor-supply decisions and
output by causing shifts in expected inflation.

In this chapter,... we move from the general equilibrium models built on the
joint foundations of individual optimization and flexible prices to the class of
general equilibrium models built on optimizing behavior and nominal rigidities
that are employed in most discussions of monetary policy issues. ...

It is easy to see why nominal price stickiness is important. As we have seen in
the previous chapters, the nominal quantity of money affects equilibrium in two
ways.

First, its rate of change affects the rate of inflation. Changes in expected
inflation affect the opportunity cost of holding money, leading to real effects
on labor-leisure choices and the choice between cash and credit goods. However,
these substitution effects seem small empirically. Second, money appears in ...
the form of real money balances. If prices are perfectly flexible, changes in
the nominal quantity of money via monetary policy actions will not necessarily
affect the real supply of money. When prices are sticky, however, changing the
nominal stock of money does initially alter the real stock of money. These
changes then affect the economy's real equilibrium. Short-run price and wage
stickiness implies a much more important role for monetary disturbances and
monetary policy. ...

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Why Did Economists Reject Flexible Price Models?

I expect that some of you are completely lost in the
debate over the relationship between interest rates and inflation that has
been going on lately. I'm hoping this will provide some
general background on monetary models that will help to sort things out, at least at a very general level.

But the main reason for doing this is to emphasize something that has not
been talked about much, how the empirical evidence led economists to move away
from flexible price models and consider models featuring wage and price
rigidities (and for those of you ready to jump on me about the empirical
evidence regarding wage and price rigidities, how the evidence changes with
disaggregation and the like, those objections have been presented here, e.g. see
this post for one example, or even better, see
here, or better yet, scroll down
here).

This is an important, too little discussed point. In models with flexible
prices, matching the short-run dynamics contained in actual U.S. data with a
defensible theoretical model is a challenge, one that can only be overcome with
assumptions that are highly unpalatable. We do much better when we add wage
inflexibility, but that alone is not enough to get both the size and the sign of
all the correlations in the data correct, and it also fails to match the
magnitude and duration of the responses to shocks. When price rigidities are
tacked onto the model so that both price and wage inflexibilities are present,
we get much closer in matching signs of correlations, durations, and magnitudes contained within
U.S. data.

Even then, problems remain. One has to do with whether the actual degree of
price rigidity in the data is enough to generate the persistence and magnitudes
that are needed -- that's the point of the papers linked above. Another is the
need to assume unrealistic values for labor supply elasticities in order to get
the right degree of labor responsiveness in the model. The values needed do not
match the estimated values. In addition, the Calvo pricing assumption is often
attacked as ad hoc instead of being derived from first principles, an
unrealistic approximation of the true process (e.g. it's not state dependent), and
so forth. And this list is by no means exhaustive.

But these models -- New Keynesian models -- are the best we have presently in
terms of matching the data empirically. Some proponents of alternatives, e.g.
flexible price models, will protest that they can, in fact, do as well or better
at matching the data, but they will rely upon assumptions, decompositions, shock
characteristics and the like that the larger profession has deemed
unsupportable. When the proponents of alternatives to the New Keynesian model
produce a model of their own that does a better job of explaining the data
without resorting to these assumptions, then it will be time to pay more
attention. But for now, for policy analysis in particular, the New Keynesian
models are the best we have. I understand that, particularly recently, best does
not necessarily imply good -- the models need to be fixed and some people,
like Stiglitz don't think they can be fixed at all. But, again, for now they
are the best we have, particularly in terms of matching the empirical evidence
and for policy analysis.

This is from Carl Walsh's
book "Monetary Theory and Policy" (I need to get my hands on his 3rd
edition). The sections below provide some background on the evolution of monetary models, as
well as more on the point about needing wage and price rigidities to match the
empirical evidence:

2 Money-in-the-Utility Function2.1 IntroductionThe neoclassical growth model, due to Ramsey (1928) and Solow (1956),
provides the basic framework for much of modern macroeconomics. Solow's growth
model has just three key ingredients: a production function allowing for smooth
substitutability between labor and capital in the production of output, a
capital accumulation process in which a fixed fraction of output is devoted to
investment each period, and a labor supply process in which the quantity of
labor input grows at an exogenously given rate. Solow showed that such an
economy would converge to a steady-state growth path along which output, the
capital stock, and the effective supply of labor all grew at the same rate.

When the assumption of a fixed savings rate is replaced by a model of
forward-looking households choosing savings and labor supply to maximize
lifetime utility, the Solow model becomes the foundation for dynamic stochastic
models of the business cycle. Productivity shocks or other real disturbances
affect output and savings behavior, with the resultant effect on capital
accumulation propagating the effects of the original shock over time in ways
that can mimic some features of actual business cycles (see Cooley 1995).

The neoclassical growth model is a model of a nonmonetary economy, and
while goods are exchanged and transactions must be taking place, there is no
medium of exchange -- that is, no "money" -- that is used to facilitate these
transactions. Nor is there an asset, like money, that has a zero nominal rate of
return and is therefore dominated in rate of return by other interest-bearing
assets. To employ the neoclassical framework to analyze monetary issues, a role
for money must be specified so that the agents will wish to hold positive
quantities of money. A positive demand for money is necessary if, in
equilibrium, money is to have positive value.

A fundamental question in monetary economics is the following: How should we
model the demand for money? How do real economies differ from Arrow-Debreu
economies in ways that give rise to a positive value for money? Three general
approaches to incorporating money into general equilibrium models have been
followed: (1) assume that money yields direct utility by incorporating money
balances directly into the utility functions of the agents of the model (Sidrauski
1967); (2) impose transactions costs of some form that give rise to a demand for
money, either by making asset exchanges costly (Baumol 1952; Tobin 1956),
requiring that money be used for certain types of transactions (Clower 1967),
assuming that time and money can be combined to produce transaction services
that are necessary for obtaining consumption goods, or assuming that direct
barter of commodities is costly (Kiyotaki and Wright 1989); or (3) treat money
like any other asset used to transfer resources intertemporally (Samuelson
1958). All involve shortcuts in one form or another... An important
consideration in evaluating different approaches will be to determine whether
conclusions generalize beyond the specific model or are dependent on the exact
manner in which a role for money has been introduced. We will see examples of
results that are robust, such as the connection between money growth and
inflation, and others that are sensitive to the specification of money's role,
such as the impact of inflation on the steady-state capital stock. ...

The ... assumption that prices and wages are perfectly flexible will be
maintained... Thus, the focus is on flexible price models that emphasize the
transactions role of money. The approaches adopted in these models can also be
used to incorporate money into models in which prices and/or wages are sticky.
The implications of introducing nominal rigidities into general equilibrium
models of monetary economies are discussed in [later] chapters...

3.5 Summary
The models we have examined in this and the previous chapter are variants of
Walrasian economies in which prices are perfectly flexible and adjust to ensure
that market equilibrium is continuously maintained. The ... approaches discussed
all represent means of introducing valued money into the Walrasian equilibrium.
Each approach captures some aspects of the role that money plays in facilitating
transactions. ...

However, the dynamics implied by these flexible-price models fail to capture the
short-run behavior that appears to characterize modem economies.

That is perhaps not surprising; most economists believe that sluggish wage and
price adjustment, absent from the models of this chapter, play critical roles in
determining the short-run real effects of monetary disturbances and monetary
policy. Although systematic monetary policy can have real effects with flexible
prices, simulations suggest that these effects are small, at least at moderate
inflation rates. To understand how the observed short-run behavior of money,
interest rates, the price level, and output might be generated in a monetary
economy, we need to introduce nominal rigidities, a topic discussed in chapter
5. ...

5 Money, Output, and Inflation in the Short Run5.1 Introduction
Chapter 1 provided evidence that monetary policy actions have effects on real
output that persist for appreciable periods of time. The empirical evidence from
the United States is consistent with the notion that positive monetary shocks
lead to a hump-shaped positive response of output, and Sims (1992) finds similar
patterns for other OECD economies. We have not yet discussed why such a response
is produced.

Certainly the models of chapters 2-4 did not seem capable of producing such an
effect. So why does money matter? Is it only through the tax effects that arise
from inflation? Or are there other channels through which monetary actions have
real effects? This question is critical for any normative analysis of monetary
policy, since designing good policy requires understanding how monetary policy
affects the real economy and how changes in the way policy is conducted might
affect economic behavior.

In the models examined in earlier chapters, monetary disturbances did cause
output movements, but these movements arose from substitution effects induced by
expected inflation. The simulation exercises suggested that these effects were
too small to account for the empirical evidence on the output responses to
monetary shocks. In addition, the evidence in many countries is that inflation
responds only slowly to monetary shocks. If actual inflation responds gradually,
so should expectations. Thus, the evidence does not appear supportive of
theories that require monetary shocks to affect labor-supply decisions and
output by causing shifts in expected inflation.

In this chapter,... we move from the general equilibrium models built on the
joint foundations of individual optimization and flexible prices to the class of
general equilibrium models built on optimizing behavior and nominal rigidities
that are employed in most discussions of monetary policy issues. ...

It is easy to see why nominal price stickiness is important. As we have seen in
the previous chapters, the nominal quantity of money affects equilibrium in two
ways.

First, its rate of change affects the rate of inflation. Changes in expected
inflation affect the opportunity cost of holding money, leading to real effects
on labor-leisure choices and the choice between cash and credit goods. However,
these substitution effects seem small empirically. Second, money appears in ...
the form of real money balances. If prices are perfectly flexible, changes in
the nominal quantity of money via monetary policy actions will not necessarily
affect the real supply of money. When prices are sticky, however, changing the
nominal stock of money does initially alter the real stock of money. These
changes then affect the economy's real equilibrium. Short-run price and wage
stickiness implies a much more important role for monetary disturbances and
monetary policy. ...